Understanding Business Profit vs Cash Flow

Understanding Business Profit vs Cash Flow

Understanding business profit vs. cash flow is an important element in the finance industry. The term “cash flow” is commonly used to describe the way money enters and leaves a business’s account.

Profit, on the other hand, refers to revenue drawn from business after expenses incurred have been deducted.

Profit is the financial index that shows that a business is generally succeeding. Cash flow is what the business needs to successfully continue its operations on a day-to-day basis.

Profit can serve as a source of cash flow for a business. When a business is pulling in enough profit, it will have a positive impact on its cash flow.

Understanding business profit vs. cash flow will help you identify the key factors that are driving the finances of your business.

Measuring your cash flow and profit makes it easier to see if your business goals and its current financial performance align. A solid grasp of these two aspects can also help you improve the financial performance of your business.

How business profit and cash flow works

One measure of a company’s financial health is its cash flow. Profits show the expenses versus the income of a business; not all expenses require cash.

An example of an expense that is not spent in cash is depreciation. It is a concept in accounting that cuts down depreciable assets’ values in a profit and loss account statement. Depreciation affects profits, but it doesn’t affect cash flow.

Another financial factor that affects profits but not cash flow is inventory. This is generally due to the timing of the expenditure.

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What is business profit?

Business profit refers to the value and amount of money that result from accounting after subtracting all business expenses. When you subtract expenses like interest payments, cost of operation, payment of loans, and taxes, what remains is your profit.

Generally speaking, the proprietor of a sole proprietorship keeps all profits earned by the company. In a large business, for instance, a corporation, the profit is paid in dividends to the shareholders.

The shareholders have a choice after receiving their share of the profit. One is to invest their dividend in the business, support the growth of the corporation, and get more revenue. The other is to retain their share of the profit.

Types of business profit

There are three major types of profit that every business makes. These types of profit include;

  • Gross profit
  • Net profit
  • Operating profit

Gross Profit

The gross profit is the profit that your business records after you have accounted for the costs of production. It is the result of subtracting the cost of manufacturing products or providing customers with your business’ services.

Cost of goods sold (COGS) refers to the sum of all expenses incurred in the production or delivery of a good or service. Gross profit is calculated thus;

Gross profit = Sales (revenue) – COGS

Where:

COGS – Cost of goods sold

Net Profit

The net profit refers to what remains of the gross profit from your business after you have deducted all expenses. All costs associated with making or delivering a product or service are included here.

Net profit is the result of subtracting interest payments, tax payments, and operating expenses, among others. It is calculated thus;

Net profit = Gross profit – interests, taxes, operational costs, etc.

Operating Profit

The operating profit is the total earnings that a business gains from its chief business activities during a particular period. In operating profit, interest and taxes are not included.

What is cash flow?

The inflow and outflow of cash during a given time period is known as the company’s cash flow. It’s the sum total of all deposits and withdrawals made to and from your company’s chequing account.

It is an efficient metric that you can use to evaluate your business’s performance both in the short and long term.

Your business’s cash flow can either be negative or positive. Cash flow is negative when your business pays more cash (money goes out) than it receives in a certain period.

That is, your business spends more than it gets from clients. Negative cash flow is bad for your business.

Conversely, a company has positive cash flow when it receives more cash (money coming in) than it spends. That means your business gets more from customers than it spends. Positive cash flow is good for your business.

Net Change in Cash

“Net change in cash” is like a summary of a company’s money situation over a certain period of time. It could be a month, three months, or even a year. It’s a way to find out if the company ended up with more or less money than it started with.

Types of cash flow

There are four types of cash flows which include;

  • Cash flow from operating activities
  • Free cash flow to equity (FCFE)
  • Cash flow from financing activities
  • Free cash flow to the firm (FCFF)

Cash Flow from Operating Activities

Cash flow that comes from operating activities refers to the cash flow that your business generates from performing its core activities. The operating activities of a business include cost payoffs, the generation of revenue, and the payment of working capital.

Free Cash Flow to Equity (FCFE)

After all investments have been made in the company, the remaining cash is referred to as “free cash flow to equity” (FCFE).

Cash Flow from Financing Activities

Money your company brings in thanks to its financing endeavours is known as “cash flow from financing activities.” These include equity, the payment of dividends, the repurchasing of shares, and debt payment and issuance.

Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm (FCFF) is used by large corporations in their financial modelling and valuations. It is an assumed cash flow where a business is believed to have no debt or leverage.

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Business profit vs cash flow: which is more important?

Cash flow and profit are both important and necessary for your business for several reasons. They can both be used to monitor your company’s progress and spot patterns over time. However, the aspects of your business’s financial performance that they track are different.

For instance, cash flow can show you trends in negative and positive cash flows. This information may help you make financial decisions that ensure you pay off immediate expenditures on time. Cash flow management is important at every stage of your business.

When you don’t have a ready emergency cash supply, you will have problems under disaster conditions like a pandemic. One reason, of course, is that customers usually don’t come in under such circumstances. There is a saying that “cash flow is king,” and this is true, especially if you have a small business.

If the income your business generates isn’t sufficient to pay bills, your business may be facing closure before profit is made. This is exactly why a startup business is the riskiest business to invest in, both for lenders and investors.

Profit, on the other hand, is an indicator of sales and overall trends in business expenses. It helps you align your business goals with the actual performance of the business.

Lenders and investors will have more faith in your company’s continued success if it can demonstrate a track record of profitability over time. It assures them that your business can survive in the long run.

A proper analysis of the profit performance of your business can help you discover if it follows seasonal trends. The result of the analysis will show you how your business performs when its services and products aren’t trending. After all, seasonal trends impact financial performance.

Understanding business profit vs cash flow conclusion

A good understanding of business profit vs. cash flow can give you ideas on how to improve your business’s performance.

Business profit indicates how your business is performing and gives a good comparison between actual performance and business objectives. Cash flow is needed to run the day-to-day activities of a business.

It is the profit you make from your business that tells you whether your business is succeeding or not. And while cash flow is necessary for running the business, profit can be a source of cash flow.

Cash flow vs profit is important to your business. They complement each other in that a business can have negative cash flow and still make a profit.

Thanks for checking out understanding business profit vs cash flow.

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FAQs about understanding business profit vs cash flow

What’s the difference between cashflow and profit?

Cash flow represents the amount of money that goes in and comes out of your business at a particular time. Profit is the money that stems from subtracting costs from the revenue of your business. A company's ability to turn a profit is a key performance indicator. Cash flow, on the other hand, is the capital that is needed to keep the business running. Meaning that profit evaluates the ongoing stability of your business while cash flow assesses the business’ ability to pay bills.

Does profit impact cash flow?

Yes. Profit impacts cash flow in that profit can be the source of cash flow for a business. However, profit isn’t the only factor that brings cash flow into a business.

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June 4, 2023
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